Heed The Words Of Warren Buffett When Shopping For Smart Beta Solutions

In the last several years, a new approach to investing, called smart beta, has taken hold in the investment industry. Smart beta approaches often strike a balance between active and passive investing: the manager often passively follows systematic index rules, but those rules differ from traditional market capitalization based construction. Typically, smart beta emphasizes capturing an investment factor or objective.

There are few who would not agree that Warren Buffett is one of the greatest investors ever. His annual letters have long been scrutinized and combed over for pearls of wisdom. While Warren Buffett has not said much on smart beta specifically, an investor evaluating smart beta approaches can still find wisdom and lessons in his words.

“Risk comes from not knowing what you are doing.”

When it comes to investing in smart beta, not all approaches are made equal. In fact, some approaches do not even deliver what we expect from them based on their names. For example, consider the many popular growth and value indices. Our expectation is that a value index will tilt towards cheap companies and away from expensive ones.

Unfortunately, growth and value are often marketed as different ends of the same spectrum when in reality they are two unique axes. So while most value indices do tilt towards cheap over expensive, they also tend to tilt towards “not growth.” Put another way, when you’re buying value you’re often really buying cheap, but shrinking companies. When you’re buying growth you’re often buying growing, but expensive companies.

The takeaway: When evaluating a smart beta solution, make sure you dig into the index methodology to make sure you understand exactly the process you are investing in.

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”

At the end of 2013, Vanguard posted a tongue-in-cheek blog post about their new “AlphaBet Portfolios” – 26 new portfolios that would equal-weight stocks beginning with a given letter. The post demonstrated that each and every one of then 26 new portfolios outperformed the S&P 500 on a total return basis over the 19-year backtest.

Now the fun part: combining the portfolios! Using the S, M, A, R, and T portfolios, we can build a SMART-beta portfolio. Or, for the ultimate self-reflecting portfolio, spell our own name! And they’ll all have spectacular performance. Surprised?

We shouldn’t be. The equal-weight methodology employed to build each portfolio implicitly tilts the portfolios towards the size and value factors – factors that have been demonstrated to historically generate excess risk-adjusted returns.

The takeaway: Vanguard’s post highlights the importance of looking behind the curtain of a marketing scheme. We should have a healthy dose of skepticism with backtests and seek approaches that are supported by both evidence and theory.

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

Diversification is one of the most powerful tools at an investor’s disposal: but over-diversification can be detrimental. When it comes to smart beta, there is a fine balance between the concentration necessary to capture a factor and the diversification necessary to manage its risk. Consider the ETFs in the large-cap value category in ETFdb.com. Evaluating past returns, we can see just how much exposure these ETFs have to the “value” factor.

We find a diverse crowd, despite being in the same category. iShare’s S&P 500 Value ETF (IVE) has about half the exposure to the “value” factor that Guggenheim’s S&P 500 Pure Value ETF (RPV) has.

The takeaway: In selecting smart beta ETFs, be careful that you aren’t just picking closet cap-weighted indices.

“No matter how great the talents or efforts, some things just take time. You can’t produce a baby in one month by getting nine women pregnant.”

There are many approaches that have historically outperformed the market on a risk-adjusted basis, including value, size, momentum, quality, and low volatility. Each of these approaches, however, can go through prolonged periods of underperformance.

Below we can see just how much the performance of a value approach can vary. The graph plots rolling 1-year performance difference between cheap and expensive stocks. We can see that in some periods, like the late 90s, cheap stocks underperformed their expensive peers by nearly 40%, only to rally and outperform by 60%.

This sort of short-term relative performance volatility can be stomach turning. However, I believe it is necessary if the long-term expected return is going to positive. Why? If the approach were easy, too many people would do it and it would be arbitraged away. By being difficult to stick with, the premium can continue to exist.

The takeaway: Approaches will come in and out of favor. If we believe in the long-term efficacy of an approach, we should stay disciplined in our allocation.